James Carville said twenty years ago that he wanted to be reincarnated as the bond market because the vigilantes had so much clout over policymakers. But in the New Normal world, he might wish to be reincarnated as the Asian equity markets because they are where traders in Europe and the U.S. look to see if it is a “risk on” or “risk off” day. With so much money chasing fewer assets with known return distributions, and with reliable investment rules of thumb scarce, frequent flips between “risk on” and “risk off” days will likely be a continuing symptom of the Knightian uncertainty that still, to some extent, hangs over global financial markets. Uncertainty is less chronic and its impact less systemic than in the first year or so of the global financial crisis, but it has not disappeared. Unlike October 2008, markets are now open and assets trade, but they trade at clearing prices that reflect daily news about the relevant, headline-grabbing tail events. For example, a Chinese growth slowdown suggested by a leading indicator report signals “risk off,” while the Dodd-Frank bill passing the conference committee with a watered-down Volcker rule signals “risk on.”
Lower Leverage
Third, because harvesting alpha in the New Normal will require getting the tails right, successful investment strategies in a New Normal world will generally be less levered than during the Great Moderation. Note that this is a consequence of the New Normal itself and not merely the outcome of tighter regulation, which itself is almost surely to discourage leverage. The contrast is instructive: In the Great Moderation years (roughly 1987–2007) of predictable policy, low inflation, and modest business cycles, generating alpha meant adding leverage to boost the returns realized by bunching close to the mean. As more leverage was piled on to the system, spreads shrank, which induced adding even more leverage to reach return targets. In a New Normal world, the cost of debt financing to fund speculative trades must go up. The lender does not benefit from the fatter right tail of borrower profits if that right tail is symmetrically matched by a fatter left tail of borrower losses. And the bias against leverage is only more pronounced if (as I suspect) left tails are not only fat but asymmetrically larger. As my colleague Paul McCulley likes to say, “Markets usually don’t melt up.”
Bottom Line
Although it is now widely accepted we are in a New Normal with fatter tails, many investors don’t fully appreciate the key implications: First, rules of thumb and investment strategies based on mean reversion will likely be less effective or even unsuccessful in a world where realized returns rarely cluster near the mean, even though distributions with fat tails have means too! Second, with so much profit and loss riding on getting the tails right, fluctuations in risk appetite will be more frequent, a symptom of the Knightian uncertainty that still overhangs the markets and a fact illustrated by the uncertainty over policy in Europe now. Third, the cost of debt financing to fund speculative trades must go up. The lender does not benefit from the fatter right tail of borrower profits if that right tail is symmetrically matched by a fatter left tail of borrower losses – this will be true regardless of the inevitable regulatory response that will further discourage leverage.
Investors had 25 years to get comfortable with the Great Moderation. The sooner they recognize those days are over, the better.
Richard H. Clarida Executive Vice President Global Strategic AdvisorCopyright (c) PIMCO
